News & Knowledge

SEC Proposes Pay Ratio Rule.....Do You Want the Good News or the Bad News?

After 3 years of waiting, on September 18, 2013, the SEC finally issued a proposed rule to implement Section 953(b) of the Dodd-Frank Act, also known as the “pay ratio” disclosure requirement, requiring most public companies to present a ratio of annual total CEO compensation to the median of annual total compensation of all employees (excluding the CEO), in annual reports, proxy statements and registration statements that are required to include executive compensation disclosures.

First, the good news. The pay ratio disclosure will not be required for emerging growth companies, smaller reporting companies or foreign private issuers. In addition, in what appears to be at least a slight acknowledgment to many of the concerns raised when the pay ratio requirement was included in the Dodd-Frank Act, the SEC chose to not follow the Dodd-Frank Act’s apparent mandate to calculate annual total compensation of “all” employees using the proxy statement Summary Compensation Table method for calculating total compensation. In addition, companies will not be required to include the pay ratio disclosure until the 10-K or proxy statement filed after the first fiscal year beginning after the rule becomes effective. Given the voluminous comments expected in response to the proposed rule, we believe the earliest the SEC will adopt the final rule is some time during 2014. If so, the earliest a calendar year-end company would be required to include the pay ratio disclosure would be its Form 10-K or proxy statement filed in 2016.

Now, the bad news. The pay ratio disclosure is not going away and while the SEC in the proposed rule attempts to provide companies some flexibility, the proposed rule leaves companies with a great deal of uncertainty regarding the pay ratio calculation. As proposed, the pay ratio disclosure would include all U.S. and non-U.S. employees, as well as part-time, seasonal and temporary employees, and, as described below, companies can choose from several options to determine the median annual total compensation of all employees.

The pay ratio would cover all individuals who were employed by a company or its subsidiaries on the last day of the covered fiscal year. Compensation of mid-year hires would be annualized, however, compensation of seasonal or temporary employees would not, and compensation of part-time employees would not be adjusted to a full-time equivalent. In addition, cost-of-living adjustments to address differing geographical locations would not be permitted.

As proposed, a company must identify the median employee (based on annual total compensation), disclose that employee’s annual total compensation for the last completed fiscal year and present it as a ratio or multiple of the CEO’s annual total compensation for the same year. For example, if the median of the annual total compensation of all employees is $45,790 and the annual total compensation of the CEO is $12,260,000, the pay ratio would be disclosed as “1 to 268” or as “the CEO’s annual total compensation is 268 times that of the median of the annual total compensation of all employees.”

As noted above, despite the language in the Dodd-Frank Act, the proposed rule does not mandate a specific calculation methodology for identifying the median annual compensation of all employees. A company may identify the median employee based on any compensation measure consistently-applied to its full employee population (such as annual cash compensation or amounts derived from the company’s payroll or tax records) or by using statistical sampling or any other reasonable method that is appropriate to the size and structure of the company’s business and manner of compensating employees. Once the “median employee” is determined, the company would then calculate and disclose the annual total compensation for that employee using the proxy statement Summary Compensation Table provisions. So while the determination of median employee will require additional work by companies, unlike many feared given the language of the Dodd Frank Act, as proposed, companies will only need to calculate annual total compensation using the burdensome proxy statement method for one extra employee each year (but without identifying that employee by name). The proposed rule would also permit a company to use reasonable estimates in calculating annual total compensation for employees other than the CEO.

No matter how calculated, companies will be required to include a brief overview of the methodology and material assumptions, adjustments and estimates used in the calculation of the median or the annual total compensation of employees. For example, if a company uses statistical sampling, it would need to disclose the size of the sample versus the estimated full employee population, as well as material assumptions used to determine the sample size and how the sampling method addresses issues of separate payrolls for different employee populations.

In order to avoid unfair comparisons for average workers, where various perks could account for a larger percentage of the employee’s annual total compensation, the proposed rule makes clear that companies are permitted but not required to exclude perks below $10,000 from the calculation of annual total compensation. If a company includes such perks for the median employee, however, it must apply the same approach when presenting the CEO’s annual total compensation in the pay ratio disclosure and explain any differences between the pay ratio disclosure and the amounts reflected for the CEO in the Summary Compensation Table.

While the pay ratio disclosure rule is not yet final and likely will not require disclosure before the 2016 proxy season, it is clear that pay ratio disclosure is not going away. The SEC’s decision to provide a flexible approach to the calculation means that there will not be any meaningful way to compare the pay ratios of peer companies. It also opens the door for proxy advisory firms and activist shareholders to further exert their influence by mandating a single method of calculation or risk "no" votes. Unfortunately, as SEC Commissioner Daniel M. Gallagher stated “The pay ratio computation that the proposed rules would require is sure to cost a lot and teach very little.”

Companies should begin considering appropriate methods for calculating their median of annual total compensation of all employees (excluding the CEO) so they can begin to understand what these disclosures will look like and how much work will be necessary to prepare for them.